Dimensional Fund Advisors Part IV

This article is one in a long series which I hope will help explain the ins and outs of DFA – Dimensional Fund Advisors. NOTE: This is my interpretation and explanation only. For the final word, please refer to the DFA Canada Website.

Okay, so today we are going to talk about some of the differences between investing and gambling. Rather, I should clarify that this is my own personal take on it – if you look up “investing” you may find many different explanations from the one I present here. Feel free to debate it as I think of it as more of a fluid concept rather than a hard and fast delineation.

Gambling

It’s probably best to draw an analogy with going to a Casino. Every now and then, someone comes out ahead. Even more rarely, someone wins big. But for the most part, the house always wins and more people have stories about how they lost money rather than won it.

The potential of making lots of money in a short period of time is the appeal of gambling, or playing the lottery. Consider the lifelong lottery player. If they were to spend $20/week for 40 years (yes there are people who do this) they will have spent $41,600 on lottery tickets. If they had instead regularly added $20/week into an indexed portfolio of equities over 40 years, you might expect a long term rate of return of perhaps 8%. Had they done this, they might have slightly over $300,000 at the end of 40 years.

The odds of winning the 6/49 are approximately 1 in 13,983,816 according to this website. Compare this to perhaps a 9 in 10 chance of having $300,000 by the time you retire. If people were completely rational, they would just stick with investing in an indexed portfolio over playing the lottery. But of course, people are not Vulcans. I play the lottery on occasion too – even though I know the odds are against me. The reason I play, and the reason most other people play, is that you have the chance of creating incredible wealth in a very short period of time. Instant gratification.

Investing

Investing is boring (relatively). There is almost no instant gratification in the sense that you will never create phenomenal wealth in a very short period of time. I define investing in equity markets as the participation in the long term growth that the capital markets overall will provide. I believe Capitalism works, and that the market does a fairly good job of setting relative prices with respect to risk and return.

A true investor looks at a stock and sees a business first and foremost. A gambler looks at a stock and sees a number first and foremost. However, even for the investor, there can be elements of gambling.

Most Investors are Gamblers

I’ve given an extreme example of what a “gambler” is, and I don’t anyone to shoot me for saying this but most investors are gamblers to varying degrees. Fortunately the dichotomy between investing and gambling is not as extreme as between playing the lottery versus systematically saving to a well diversified portfolio. But let me provide an example: I recently spoke with someone who posited that by just selecting the top 10 companies by market cap in the market, they would’ve handily beaten the mutual funds his advisor had put him into over the last 10 years. That may very well be true. However, simply because a strategy may have worked out better does not make it qualify as prudent investing. Picking the 10 stocks still has an element of gambling in it.

Let’s suppose we had a very well respected analyst from Bay Street (or Wall Street) who was really known for doing his homework. He decides to pick only three companies to invest his own personal money in because he wants the biggest bang he can get for his buck. No one could accuse this guy of not knowing what he was buying and based on his analysis he could convince anyone that his decisions were sound. But what if one of the companies he bought had improper accounting and ended up going bankrupt suddenly? One third of his portfolio will have vanished. This example is just to show that no matter how well you think you know a situation, you can’t account for “life” happening.

Setting The Record Straight

I want to be clear that when I refer to prudent investing I am referring to the fact that you are making a trade-off. Prudent investing is giving up the chance at a making a killing for the certainty of never getting killed. It’s possible to stray a bit from prudent investing and take small bets against the market, and it’s possible to stray a lot from it by taking large bets against the market (by only investing in one area, or sector, or even just a handful of stocks for example).

DFAs approach is very much along the lines of not betting against the market. But while people may point to the DFA fund returns being different from the market returns I will give a bit of a prelude now: what most people believe to be the “market” is actually not the market… (more on this later)

In Part V on the DFA series, we will look at systematic versus non-systematic risk. I was going to include it in this post, but it would’ve been too long. Our discussion of CAPM (Capital Asset Pricing Model) will begin in Part VI.